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Wednesday, December 31, 2008

I get to close out 2008 on hospital room duty with my son. He's doing well - had his breathing tube out yesterday, is eating regular food, and slowly recuperating. He should be moved out of the ICU tomorrow and into a regular room. With some luck, he might be home by Monday the 5th.

The Unknown Wife and Daughter are going to a neighbor's house for a little New Year's cheer (the non-alcoholic kind, since Unknown Wife is expecting), and then home by about 10.

There's been a lot of talk in recent months about "synthetic debt". I just read a pretty good explanation of synthetics in Felix Salmon's column, so I thought I'd give a brief summary of what it is, how it's used, and why.

First off, let's start with Credit Default Swaps (CDS). A CDS has a lot of similarities to an insurance policy on a bond (it's different in that the holder of the CDS needn't own the underlying bond or even suffer a loss if the bond goes into default).

The buyer (holder) of a CDS will make yearly payments (called the "premium"), which is stated in terms of basis points (a basis point is 1/100 of one percent of the notional amount of the underlying bond). The holder of the CDS gets paid if the bond underlying the CDS goes into default or if other stated events occur (like bankruptcy or a restructuring).

So, how do you use a CDS to create a synthetic bond? here's the example from Salmon's column:

Let's assume that IBM 5-year bonds were yielding 150 basis points over treasuries. In addition, Let' s assume an individual (or portfolio manager) wanted to get exposure to these bonds, but didn't think it was a feasible to buy the bonds in the open market (either there weren't any available, or the market was so thin that he's have to pay too high a bid-ask spread). Here's how he could use CDS to accomplish the same thing:

First, buy $100,000 of 5-year treasuries and hold them as collateral

Next, write a 5-year, $100,000 CDS contract

he's receive the interest on the treasuries, and would get a 150 basis point annual premium on the CDS

So, what does he get from the Treasury plus writing the CDS? If there's no default, the coupons on the Treasury plus the CDS premium will give him the same yearly amount as he would have gotten if he's bought the 5-year IBM bond, And if the IBM bond goes into default, his portfolio value would be the value of the Treasury less what he would have to pay on the CDS (this amount would be the default losses on the IBM bond). So in either case (default or no default), his payoff from the portfolio would be the same payments as if he owned the IBM bond.

So why go through all this trouble? One reason might be that there's not enough liquidity in the market for the preferred security (and you'd get beaten up on the bid-ask spread). Another is that there might not be any bonds available in the maturity you want. The CDS market, on the other hand, is very flexible and extremely liquid.

One thing that's interesting about CDS is that (as I mentioned above), you don't have to hold the underlying asset to either buy or write a CDS. As a result, the notional value of CDS written on a particular security can be multiple times the actual amount of the security available.

I know of at least one hedge fund group that bought CDS as a way of betting against housing-sector stocks (particularly home builders). From what i know, they made a ton of money. But CDS can also be used to hedge default risk on securities you already hold in a portfolio.

To read Salmon's column, click here, and to read more about CDS, click here.

Thursday, December 25, 2008

We just got som bad news regarding the Unknown Son. As many of my regular readers already know, he's gone through a lot - he's a two-times cancer survivor.

In 2002 he was diagnosed with Neuroblastoma, a particularly nasty and resistant childhood cancer. After a great deal of chemotherapy, surgery, radiation, more chemotherapy, and experimental treatments (including an autologous (i.e. "self") stem-cell transplant, he went into remission in 2005.

In January of 2008, he was diagnosed with a Wilms' tumor (a kidney tumor), which resulted in the removal of his right kidney and, after more chemo, he was given another clean bill of health this summer.

Now it looks like he has another tumor - in the lower part of his right lung. We just found out about it two days ago as a result of routing follow-up scans. He's scheduled for more surgery this coming Monday (the 29th). He'll get the tumor removed, which will give us the best information as to what exactly it is. He'll probably have about a week-long hospital stay, and we'll then know if this is a recurrence of the Wilms, tumor or something else (it could be a recurrence of his neuroblastoma, but that's unlikely because there was no indication on his latest MIBG scan a couple of weeks back).

So, please keep us in your prayers.

If you're one of my "non-blogosphere" friends (or a regular reader who knows me by my real name) and you want to keep up with what's going on, we maintain a website that we use to keep family and friends abreast of the little guy's treatment. Drop me an email and I'll send it to you in case you want the url.

Monday, December 22, 2008

The answer is that they're all games that mutual fund managers play at the end of the year to make their portfolios' performance look better. The Investing section of today's Wall Street Journal has a short piece that describes these games:

Window dressing happens when the portfolio manager sells off securities just before the end of the reporting period so that they don't show up in the annual (or quarterly) listing o the portfolio's securities.

Painting the Tape (also called Banging the Close) occurs when a portfolio manager holding a security buys a few additional shares right at the close of business at an inflated price. For example, if he held shares in XYZ Corp on the last day of the reporting period (and it's selling at, say $50), he might put in small orders at a higher price to inflate the the closing price (which is what's reported). Do this for a couple dozen stocks in the portfolio, and the reported performance goes up. Of course, it goes back down the next day, but it looks good on the annual report.

Comparison Shopping could also be called "benchmark shopping". This refers to the idea that if a fund manager can't beat his benchmark, he just switches to a new benchmark that he can beat.

I try to keep politics mostly out of Financial Rounds because it generally gets people far too worked up. Likewise, I try not to post too much about President Bush. But this piece in the Washington Post caught my eye.

For much of the past seven years, President Bush and Vice Prresident Dick Cheney have waged a clandestine operation inside the For much of the past seven years, President Bush and Vice President Dick Cheney White House. It has involved thousands of military personnel, private presidential letters and meetings that were kept off their public calendars or sometimes left the news media in the dark.

Their mission: to comfort the families of soldiers who died fighting in Afghanistan and Iraq since the Sept. 11 terrorist attacks and to lift the spirits of those wounded in the service of their country.

Saturday, December 20, 2008

I didn't realize this, but every year Harvard's Kennedy School invites new members of congress for a three-day "briefing" by Harvard profs on various topics. This year, Jeff Frankel came up with a graphic explanation of the current economic crisis. Here it is:Now that's what I call an information-rich slide.

Thursday, December 18, 2008

Section 13(f) of the Securities Exchange Act of 1934 requires all institutional fund managers with more than $100 million in assets to report their holdings each quarter to the SEC *(within 45 days of the end of the quarter). The hard copies of these filings go back 30 years, but they've been available for free online through the SEC's EDGAR database since 1999. The form name is (not surprisingly) "13F" or "13F-HR". Like many academics, I've used the electronic database of 13F filings put out by Thomson Financial (which has information back to the early 80s on electronic media, runs 5-10 gigabytes, and requires you to have some programming chops to access) in my research. But you can access a fund's data one filing at a time through the Edgar site.

It won't show things like derivatives holdings (at least usually not) or short sales. But if will give you an interesting look at the holding of the big boys. However, you might be looking at a portfolio as much as 45 days old. So, it's best for funds with a long-term (usually value-oriented) approach. As one example, here's the latest filing from Seth Klarman's Baupost Group.

Wednesday, December 17, 2008

Add the name Eliot Spitzer to the list of prominent people allegedly ripped off by Wall Street trader Bernard L. Madoff. Yesterday at Slate's holiday party Spitzer, who is writing a column for the online publication, confirmed that his family's firm had investments with a Madoff subsidiary.

I love it when two stories intersect (however loosely). It sounds like the Seinfeld episode "The Pool Guy"when George's girlfriend Susan starts being friends with Elaine.

Tuesday, December 16, 2008

I gave my last exam (to my MBA class) last night. I thought it was a pretty easy one, but as usual, there were three students (out of twenty eight) still working at the end of three hours' time. I've come to the realization that I could give four hours (or even five) for an exam, and there would STILL be a few people working to the bitter end. A few observations from the exam (none of them surprising):

My favorite student got the Terry Pratchett/Discworld references sprinkled on the exam, and one of my others caught a couple of 1980s movie references.

In between walking up and down the aisles, I wrote about a hundred lines of SAS code

One of my students already has sent an email asking if we can meet "to discuss his grade." Anyone want to guess how that'll play out?

Now all I have to do is grade them, set grades for the semester, and wait for the inevitable emails arguing for higher grades.

Monday, December 15, 2008

Winner's curse is the well-known phenomenon where the winner of an auction is often just the person who's most likely to have overpaid for the item in question. So, often the winner is the loser.

Then I heard about Swoopo.com. It's been called "pure distilled evil in a business plan". Here's their setup:

Bidding for an item starts at $0.15

Each bid raises the price by $0.15

Bids cost $0.75 to make.

Here's the kicker - a bid in the final seconds extends the auction for 15 seconds. So, auctions can go on and on.

Of course, they post the "savings" you would receive if you bought the item at the current price as a prod for people to continue betting.

They also hold "penny auctions" on their front page - a bid only increments the price by a penny. I recently saw a TomTom GPS sold for about $12. That means 1200 bids at $0.75 per bid, for revenue of $900, on something that costs them between $300 and $500. Not too shabby.

This is a behavioral economist's dream - it has bidders focusing on sunk costs (I have to make back my bids, and if I win, I get the savings), hubris, and endowment effects (the bidders start viewing the item as "theirs", and therefore value it more highly). And if I thought about it a bit, I could probably come up with other behavioral biases.

It has some similarities to a "dollar auction". In this setting, individuals bid on a dollar. But the catch is that the second highest bidder must also pay their bid, but without getting the dollar in exchange. So, the second place bidder continues to escalate to cut their losses. In Swoopo's setup, the 2nd place bidder isn't obligate to pay, but once they're in the game, they continue bidding to recoup their already-paid bids (that is, if they can get the item at a discount).

It's not a scam per se, because everything is disclosed up front - the rules are clearly stated. But the only advice I can give you about using Swoopo comes from War Games (the 1983 movie starring a very young Matthew Broderick):

UPDATE: Here's a perfect example of how the irrational bidding that can take place - a person "won" an auction for a Sharp 42 inch LCD TV. According to the website, it was "worth up to" $1,199. The "winning" bidder paid $3,360. Assuming that this was a "normal" auction with bid increments of $0.15, this means that Swoopo received total bids of (3,360/0.15) x $0.75 = $16,800 in total bids (including $1,512 from the "winner" alone), in addition to the winning bid of $3,360, for a total of $20,160 -- all for an item worth at most $1200.

UPDATE2: as pointed out by a reader, the auction above was a "fixed price" one where the "winner" got to purchase the item for $119. So, the buyer could have potentially gotten it for a very nice proice. However, they ended up spending over $1500 in bids, plus the $119 winning price, all for a TV that was worth at most $1200. So, the winner endend up overpaying by at least $400, and Swoopo made total revenue of almost $17,000 for the cost of a $1200 TV.

One part of me wishes I'd thought of this - in about a couple of days time I'd have made back all the money my retirement accounts lost this past year. But I'd feel a little bad getting that money from stupid people. Not to say I wouldn;t do it, but I'd feel a little bad.

One of my students is interviewing soon for an internship in an investment bank's fixed income department, and another is going to be starting soon in a credit analyst position, So, these pieces on distressed debt investing were pretty timely.

Michelle Harner over at the Conglomerateposted a very nice piece with some links about distressed debt investing. She highlights the difference between "vulture investing" and "investing for control" (basically traders vs. longer-term investors). She gives a couple of pretty good references. One, from Knowledge@QWharton lays out the basics of "distressed for control" investing:

Simply put, their line of work is to make a profit from companies that have failed to do so and are on the brink of bankruptcy. Unlike traditional hedge funds, however, their investment doesn't stop at buying significant portions of these companies' debt for pennies on the dollar, tidying up the balance sheet and then selling at a higher price. Instead, KPS and Matlin Patterson get in and stay in -- bringing in new managers, installing a new strategy, renegotiating labor and supplier contracts, and so on. (That's the 'control' part.) It's not an easy task, especially given the state of these companies when they step in.

She also cites some of her own research: a survey titled "Trends In Distressed Debt Investing: An Empirical Study of Investors' Objectives" (available on SSRN here).

Finally, Marketwatch gives us a look into the world of "vulture investors." It's a bit dated (April), but it shows how busy the world of distressed debt has become. One of the guys at my church's men's group is an analyst at a local distressed-debt hedge fund. He said he hasn't had this many good choices to buy since he can remember (luckily his firm is sitting on some cash).

I'm teaching the Level 1 Fixed Income material for CFA this spring, and will be teaching Unknown University's Fixed Income class in the fall. So, I'll probably be posting more on the credit market topics as time goes on (I tend to use this blog as a handy place to keep class-related stuff I want to remember).

Sunday, December 14, 2008

I give my last final exam of the semester tomorrow to my MBAs. Just for the heck of it, I named all the companies and individuals in the problems after characters from Terry Pratchett's Discworld novels. I wonder if anyone in the class will notice?

From 1991 to 2005, Bill Miller (superstar mutual fund manager for Legg Mason's Value Trust) beat the S&P every year - a record no other manager has ever come close to matching. Then, this last year the bottom fell out and his fund lost 58% (about 20% more than the typical fund.

The Wall Street Journal has a great interview of Miller, and here's the best line:

This meltdown has provided a lesson for Mr. Miller and other "value" investors: A stock may look tantalizingly cheap, but sometimes that's for good reason.

It's a very good piece for discussing in class, since it touches on a lot of issues related to market efficiency. Read the whole thing here.

Tuesday, December 09, 2008

The term "Value Premium" refers to the empirical observation that firms with low price multiples (i.e Price/Book, Price/Earnings, Price/Cash Flow) have tended to have higher returns than their high-multiple counterparts - even after controlling for risk. People give a lot of possible reasons for this - we have a bad model for controlling for risk, there are behavioral biases, or it's simply a case of data diving.

I just came across a paper by a group known as the Brandeis Institute titled "Value vs. Glamour: A Global Phenomenon" that seems to rule out the data diving story. They examine the evidence for the value premium both across time (the mid 1960's to the present) and internationally. They found that

While the degree of outperformance of value stocks vs. glamour stocks varied across data sets, what strikes us as most significant was the consistency the value premium exhibited:

One of the things I like about this career is that it has a rhythm to it - we have new "crops" each semester, and a feeling of accomplishment once the semester is done. But that final week or two is always a bit crazy.

So, to all my readers: If you're a student, good luck on your exams and projects. If you're faculty, hang in there - it's almost time for the break.

Wednesday, December 03, 2008

Al Roth (the George Gund Professor of Economics at Harvard) is extremely well known in the fields of game theory and market design. For just a few examples, he's published highly cited work on the market for donor organs, matching medical students with residencies, and matching public school children with schools. He also

Now he has a blog, titled (appropriately enough) Market Design. It's definitely worth a look-see.

Monday, December 01, 2008

This weekend I posted a video of a "whiteboard" talk by Paddy Hirsch of Marketplace, in which he explains CDOs and the credit crisis. Here's another one where he explains Credit Default Swaps (CDS) using the analogy of an arctic expedition. Since I'm teaching Fixed Income next year, I'm sure some of these will make their way into my class.